Economic Growth Weakens Again, But Recession Is Not ImminentGrowth of real gross domestic product (GDP) slipped to an annual rate of 1.3% in the first quarter of 2007, according to the “advance” estimate released by the Commerce Department on April 27. This was the slowest pace in about four years and weaker than the consensus estimate as downside surprises showed up in federal defense spending, net exports and business inventory investment.

As expected, the housing production component of GDP (residential fixed investment) exerted a major drag on economic growth in the first quarter, contracting at a 17% annual rate and lopping a full percentage point off the GDP growth rate.

The negatives from RFI were not quite as large as during the second half of 2006, although the downtrend clearly remained in place as the first quarter drew to a close.

Despite the weak first-quarter GDP performance, the economy is not likely to slip into recession during 2007. The drag from housing probably will ease off as the year progresses, several features of the weak first-quarter GDP report suggest that growth will pick up in the second quarter, and we expect further improvement in the second half of the year.

Our current forecast pegs GDP growth at 2.1% for 2007 (year-over-year) and we place the probability of recession within the next 12 months at 25% — close to the May Blue Chip consensus.

Labor Market Weakens Modestly, Pretty Much on Schedule
The marked slowdown in GDP growth since early last year now is showing up in the national labor market, pretty much in line with normal lags in this relationship.

Payroll job growth slipped to 88,000 in April, following some downward revisions to February and March, and the unemployment rate ticked up to 4.5%. Furthermore, average weekly hours ticked down in April and growth of average hourly earnings decelerated to some degree.

Employment in residential construction — builders and specialty trade contractors — edged down in April, although the cumulative decline from early last year is quite modest in comparison to the major decline in residential construction activity.

The length of the average workweek in this sector has shrunk by about an hour during the past year, helping to reconcile the large differential between construction activity and labor input. However, our estimates of productivity (output per hour) in residential construction still show major contractions in 2006 and early 2007.

A U.S. Labor Department source suggests that some construction companies may have been switching their activity from the shrinking residential market to the expanding nonresidential construction sector while still classifying the activity of their firms as residential in the monthly employment surveys.

Looking forward, we expect overall payroll employment growth to proceed at a modestly sub-par pace as GDP growth runs at a below-trend pace in coming quarters, and the unemployment rate should continue to gravitate upward in that environment. This process will open up a degree of “slack” in labor markets and help hold down unit labor costs, much to the liking of our inflation-wary central bank. [return to top]

Core Inflation Moderates in Line With Expectations
The Federal Reserve has been preoccupied with the course of core inflation in the U.S. economy, stressing the risks of upward inflation pressures even as economic growth has slowed and the labor market has lost some forward momentum. But recent signals suggest that core inflation may now be moderating, in line with NAHB’s forecast as well as the hopes and expectations expressed by Fed representatives.

The Fed’s key inflation gauge, the core price index for personal consumption expectations (PCE), increased at a year-over-year rate of 2.2% in the first quarter as a whole, in line with the average for 2006 and still significantly above the upper bound of the Fed’s implicit tolerance range for this measure (1.0% to 2.0%). However, the March reading receded to a 2.1% pace (year-over-year) and showed no change on a month-to-month basis.

Our forecast continues to show systematic deceleration of core PCE price inflation on a quarterly basis, heading for year-over-year increases of less than 2.0% by 2008. If this pattern materializes, the economy will be posting near-trend GDP growth, near-trend job growth and benign inflation at the same time — quite a success story from the Fed’s point of view. [return to top]

The Fed Holds Steady Again, and Long-Term Rates Remain Low

As expected, the Federal Reserve held monetary policy steady at the May 9 meeting of the Federal Open Market Committee (FOMC), maintaining the 5.25% federal funds rate target that’s been in place since mid-2006. By the way, this decision maintained the “real” funds rate at roughly 3%, apparently a slightly restrictive monetary policy stance.

The May 9 FOMC statement noted that “the adjustment in the housing sector is ongoing,” the same wording as in the March 21 FOMC statement, but quite different from Jan. 31 when the FOMC said that “some tentative signs of stabilization have appeared in the housing market.”

Of course, the January statement was issued before the highly visible blowup of the subprime mortgage market — an event that provoked another down leg to the dramatic housing correction.

Financial market participants fully anticipated the May 9 FOMC interest-rate decision, and the statement did not provoke noticeable changes in long-term interest rates. Both long-term Treasury and prime fixed-rate mortgage yields remained within the historically low ranges that have prevailed for some time, and we’re expecting little change in the interest rate structure over the balance of the year.

The Vacant Housing Inventory Climbs to Higher and Higher Records
The Commerce Department reports that the number of vacant year-round housing units on the market (excluding those for seasonal or occasional use) surged to another new record in the first quarter of this year, continuing the sharp upward trend that began early last year. The ratio of vacant units on the market to the total housing stock also surged to a new record in the first quarter.

While it’s hard to know what a “normal” ratio is at this time, it appears that there’s an excess of about 1.4 million vacant housing units on the market.

The recent run up in vacant housing inventory has been concentrated in for-sale units — both single-family homes and multifamily condos. But it’s important to note that the number of for-rent units on the market also has climbed to a new record, reflecting recent increases in rental vacancy rates for both the single-family and multifamily sectors.

Rental units naturally compete with for-sale units on the market and vacant units for-rent can easily convert to vacant units for-sale (or vice versa) as market conditions shift. Indeed, many investors/speculators presumably will grow weary of negative cash flows on units they acquired during the boom and now are unable to rent, compelling them to unload the units onto the for-sale markets — with negative implications for new-home sales and house prices. [return to top]

The Subprime-Related Tightening of Mortgage Lending Standards Is Playing Out
The meltdown of the subprime mortgage market has continued apace, and credit standards for new loans have been tightening not only in the subprime market but also in the “near-prime” (Alt-A) market and even in the prime segment.

It turns out that inadequate documentation of borrower income and debt ratios infected a broad swath of mortgage lending — not only during the housing boom but also during the 2006 housing retreat — and various types of risk layering (including piggy-back seconds) became quite common.

NAHB surveyed builders of all sizes in early May, following up on our surveys of mortgage lending impacts in March and April. About two-fifths of all builders reported adverse effects on their home sales during the previous month, and nearly three-fourths of large companies (starting more than 100 units per year) said that their sales had been reduced because of tighter mortgage lending standards. Among companies reporting adverse impacts, the median reduction was 15%.

We also found adverse impacts on sales cancellations, heavily concentrated among big builders. Indeed, four-fifths of companies starting more than 100 units per year reported adverse impacts on cancellations, and these companies (on average) said that the upswing in cancellations in April had wiped out 10% of their backlog of signed sales contracts.

The tightening of mortgage lending standards may not yet be complete, and it’s perfectly clear that the pendulum will not swing back to the exceedingly easy credit conditions that prevailed last year.

Fannie Mae and Freddie Mac have announced efforts to keep credit flowing to higher-risk borrowers, and the FHA program apparently is regaining some market share as the subprime component shrinks. But the net effect of the subprime-related tightening of lending standards on home sales is likely to be heavily negative for both 2007 and 2008. [return to top]

Deteriorating Supply-Demand Balance Is Weighing on the Housing Outlook
The housing markets already are heavily oversupplied with vacant units, the flow of completions of new units onto the markets still is quite sizeable, and a rising tide of mortgage foreclosures is sure to add additional supply over the course of this year and in 2008.

At the same time, the subprime-related tightening of mortgage lending standards is cutting into effective home buyer demand and preliminary analysis of recent NAHB survey data points toward further erosion of builder confidence in May (following slippage in March and April).

It is likely that the confidence of prospective home buyers has been shaken by the avalanche of media attention to the subprime debacle as well as by accumulating evidence of downward pressures on home prices in many parts of the country.

Recent revelations on the evolving supply-demand situation have prompted another downward revision to NAHB’s housing outlook for the balance of this year and in 2008. The current forecast does not show systematic improvements in home sales and housing starts until late this year and shows only a modest recovery in 2008. Our 2007 and 2008 housing starts forecasts now are somewhat below the prevailing Blue Chip consensus. [return to top]

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